Strategies for Value Creations

  

Strategies for Value Creation:

Strategies for Value Creation:

  

Its Formulation and Measurement

Its Formulation and Measurement

  Arnoldo C. Hax

  Sources of Value Creation Sources of Value Creation

Economic value is only created when the businesses

of the firm -- and the firm as a whole -- enjoy profit- ability levels which exceed that of their respective cost of capital.

• - The Market to - Book Value Model (M/B) The Market Book Value Model (M/B) - to - M - The Investor’s Perspective

  

An assessment of the present value of the expected

cash flow streaming from the assets the firm has

already in place and those from investments the firm

would have an opportunity to make some time in the

future. B - The Accountant’s Perspective Historical measurement of equity resources

  M Expected future payments = B Past resources committed • If M/B is equal to 1, the future payments are

expected to yield a fair return on the resources

committed. The firm is neither creating nor destroying value.

• • If M/B is greater than 1, there is an excess return.

  

The firm is creating value for the shareholders.

• • If M/B is less than 1, the return is under the

  

Stationary Model with Constant Growth g

Stationary Model with Constant Growth g

  Annual Profit = ROE x B Retained earnings (P)

  Dividend payments (1 - P) P x ROE x B (1 - P) x ROE x B x B (ROE - g) x B g

  Stationary Model with Constant Growth g (cont ’

  d.) Stationary Model with Constant Growth g (cont ’

  d.) Year 1 Year 2 Year t … Book value t-1 (beginning of B (1+g) B (1+g) B … year) t-1 Earnings ROE x B ROE(1+g) B ROE(1+g) B … Retained t-1 g x B g(1+g) B g(1+g) B … Earnings Dividend t-1 (ROE-g) B (ROE-g)(1+g) B (ROE-g)(1+g) B … Payments Book Value

  2 t (1+g) B (1+g) B (1+g) B … (end of year)

  Stationary Model with Constant Growth g (cont Stationary Model with Constant Growth g (cont ’ ’

  d.)

  d.) (1) M =

  (ROE - g)(1 + g) t-1

  B (1 + k E

  ) t

  Σ t=1

  ∞ (2) (ROE - g) k

• g = M B

  E

  

Valuation of 3M Stock

Valuation of 3M Stock

  Estimated Value per Share = ROE - g k

• g

  E

  x Book Value of

  3M per Share =

  24% - 7.5% x $28.72

  13% - 7.5% = $86 Actual Value per Share = $92

  The Essential Features of the M/B Model for a Firm Under Strateg The Essential Features of the M/B Model for a Firm Under Strateg y Growth y Growth The profitable firm or business

The breakeven

firm or business

  The unprofitable firm or business ROE > k

  E ROE = k

  E ROE < k

  E

M/B > 1 M/B = 1 M/B < 1

Growth will Growth will not Growth will reduce increase M/B affect M/B M/B

  The Determinants of Value Creation The Determinants of Value Creation Size of the competitive advantage, measured as • spread = ROE - k E Number of years in which the spread is maintained • = N Growth opportunities measured as rate of • reinvestment = P

  

Factors Affecting the Market Value of the Firm Under Stationary Growth

Factors Affecting the Market Value of the Firm Under Stationary Growth

for a Finite Period

for a Finite Period

  Sales margin ROS = Profit After Taxes/Sales Return on assets

  ROA = ROS x AT Asset turnover AT = Sales/Assets

Return on equity ROE

  Leverage = D/E

= ROA + D/E [ROA -

k (1-T )]

  

D C

Cost of debt = k

  D Corporate tax rate = Size of spread =

  T C ROE - k

  E Risk-free rate = r f

  Market risk

Cost of equity k = r

E f premium = (r -r ) β + (r -r ) m f

  

E m f

Beta of the stock β

  E Market value of the firm shares

  

Return on equity

ROE

Equity growth g = P x ROE

  

Retention rate (including

new equity) P

3 M/B Ratio

  IBM

  IBM International Paper Johns Manville Minnesota Mining Merck Company Inco Limited Owens Illinois Procter & Gamble Sears, Roebuck Standard Oil of California AT&T Texaco Union Carbide

  

IBM

SD

  XON MRK ACD

  Alcoa American Can Allied Chemical American Brands Bethlehem Steel Du Pont Eastman Kodak General Electric General Foods General Motors Goodyear Tire International Harvester

  IP JM MMM MRK N OI PG S SD T TX UK = = = = = = = = = = = = = = = = = = = = = = = = =

  2

  An M/B An M/B - - vs. vs. - - Spread Graph for the 30 Dow Jones Industrials (1980) Spread Graph for the 30 Dow Jones Industrials (1980)

• 8
• 4

  4

  AC ACD AMB BS DD EK GE GF GM GT HR

8 AA

  0.6

  0.2

  IP S UK T GM AA WX TX N GF UTX DD AMB GE EK PG MMM

  X BS GT HR Z OI AC JM

  ROE - k E Spread

• 8
• 6 -4 -2

  18

  Du Pont Eastman Kodak General Electric General Motors Goodyear Tire

  Alcoa Allied Signal American Express Bethlehem Steel Boeing Chevron Corp.

  IP KO MCD MMM MRK MO PA PG S T TX = = = = = = = = = = = = = = = = = = = = = = =

  IBM

  XON AA ALD AXP BS BA CHV DD EK GE GM GT

  MCD KO GE EK WX MMM AXP

  Forecast ROE less Cost of Equity (%) M /B R a ti o

  IBM UK MO MRK

  IP CHV BA S BS DD PG Z UTX PA T GT ALD

  GM AA

  22 TX

  20

  

12

  An M/B An M/B - - vs. vs. - - Spread Graph for the 30 Dow Jones Industrials (1987) Spread Graph for the 30 Dow Jones Industrials (1987)

  10

  8

  6

  4

  2

  10

  6

  3

  1

  0.8

  0.6

  0.4

  IBM International Paper Coca-Cola McDonald's Minnesota Mining Merck Company Philip Morris Primerica Procter & Gamble Sears, Roebuck AT&T Texaco

• t o
• B o o k R a ti o

  XON ALD T GE DIS PG MO MMM MRK KO

BS

  Aluminum Co. of America Allied Corp. American Express Bethlehem Steel Boeing Caterpillar Chevron Du Pont Walt Disney Eastman Kodak General Electric General Motors Goodyear Tire Int'l Business Machines International Paper Coca-Cola J.P. Morgan McDonald's

  IP KO JPM MCD MMM MRK MO PG S T TX = = = = = = = = = = = = = = = = = = = = = = = = =

  IBM

  AA ALD AXP BS BA CAT CHV DD DIS EK GE GM GT

  IBM

  CAT AXP TX UTX BA WX EK CHV

  Z

  IP UK JPM DD MCD

  Profitability of Dow Jones Industrials (1992) Profitability of Dow Jones Industrials (1992) M a rk e t

  7 GM S AA GT

  6

  5

  4

  3

  2

  1

  V a lu e

  3M Merck & Co. Philip Morris Procter & Gamble Sears, Roebuck AT&T Texaco

  

Profitability of 15 U.S. Industries (September 1987)

Profitability of 15 U.S. Industries (September 1987)

  Drug Paper &

  4.0 Food processing forest products Metals/Mining

  3.0 Integrated Advertising Hotel petroleum

  2.0 o

  Electronics ti a

  1.0 R Auto Brewing

  Shoes /B

  0.8 M Machine tools Steel-general

  Oil field services

  0.6

  0.4

  0.2

4.0 W

  0.6

  UCC

  Boise Cascade Bowater Inc. Champion International Consolidated papers Chesapeake Corp. Domtar Inc. Federal Paperboard Fort Howard Paper Great Northern Nekoosa Georgia-Pacific International Paper James River Corp. Louisiana Pacific Mead Corp. Potlach Corp. Pentair Inc. Pope & Talbot Scott Paper Temple Inland Union Camp Westvaco Willamett

  IP JR LPX MEA PCH PNTA POP SPP TIN UCC W WMTT = = = = = = = = = = = = = = = = = = = = = =

  BCC BOW CHA CPER CSK DTC FBO FHP GNN GP

  3.0

  2.0

  1.0

  0.8

  0.4

  Profitability of Paper and Forest Products Companies (Spring 198 Profitability of Paper and Forest Products Companies (Spring 198 7) 7)

  10

  8

  6

  4

  2

  IP GNN CHA CPER FHP

GP

PCH

MEA CSK WMTT SPP POP WY LPX DTC M /B R a ti o

  JR

  0.2

• 6 -4 -2 BCC TIN FBO BOW PNTA

  Profitability of Company Portfolio Profitability of Company Portfolio Specialty

  4.0 Engineering

  2.0 o

  Gears ti a

  

Flow

R

  1.0 /B M

  Building Insurance Rotary products

  0.5 Auto

  0.0 Machinery

• 5% 0%
• - Historical Equity Spreads Across Industries (1976 91) - Historical Equity Spreads Across Industries (1976 91)

18 Packaging & Container

  Hotels/Gaming Tire & Rubber Basic Chemicals

  16 Auto & Truck Mfg.

  Integrated Petroleum

  14 Metals & Mining Food Wholesalers Textiles

  Publishing

  12 Air Transport Grocery Stores Steel

  Tobacco

  10 Oilfield Services Ethical Drugs

8 Soft Drinks/Beverages

  6

  4

  2

• - Historical Equity Spreads within the Chemicals Industry (1976 91) - Historical Equity Spreads within the Chemicals Industry (1976 91)

6 Rohm & Haas

  Dow Dupont

  IFF

5 Monsanto

  Great Lakes Union Carbide WD-40 Olin

  4

  3

  2

  1